We want freedom from the fear of poverty, yet we also want hope for riches. Government provides the first in Social Security and the second in lotteries. Social Security benefits alleviate some of our fear of poverty, and lottery tickets carry some hope for riches.

The Deficit Panel, chaired by Erskine Bowles and Alan Simpson, made several recommendations for reducing our mushrooming deficits, including revisions of Social Security. The Panel’s recommendations will be hotly debated in the months ahead, and the idea of privatizing Social Security will surely come up. Some will argue, as has been argued before, that Social Security should be structured in the image of IRA or 401(k) accounts, a voluntary program where people can deposit whatever Social Security money they wish during their working years and live on whatever that money yields in their retirement years. They will also argue that people should have the freedom to invest their Social Security money in anything they wish, whether Treasury bonds, stocks, real estate or gold.

Social Security can be structured to alleviate fear of poverty or promote hope for riches, yet it is structured to alleviate fear of poverty. Social Security can be structured as a voluntary program or a mandatory program, yet it is structured as a mandatory program. Social Security can be structured with private accounts or a national account, yet it is structured with a national account. Social Security can let people to choose their investments yet it allows only an annuity with monthly payments terminating when people and their dependents die.

President Franklin D. Roosevelt explained his rationale for Social Security when he introduced it. He said: “We can never insure one hundred percent of the population against one hundred percent of the hazards and vicissitudes of life, but we have tried to frame a law which will give some measure of protection to the average citizen and to his family against the loss of a job and against poverty-ridden old age.”

It is evident from President Roosevelt’s words that Social Security was designed from the outset to alleviate fear of poverty rather than promote hope for riches. It is also evident that it was designed as an insurance program rather than a savings program or pension plan. The rich need little protection against “poverty- ridden old age,” but the poor need it. This implies that Social Security was implicitly designed to “spread the wealth,” where the poor are likely to receive more, relative to their payments, than the rich. Moreover, the structure of Social Security is implicitly designed to counter behavioral deficiencies reflected in cognitive errors and insufficient self control.

Young people with sufficient self control find it easy to buy private insurance similar to that of Social Security at a price which might not exceed the price they now pay for Social Security. But young people with insufficient self control might be tempted to forego such insurance. Moreover, people afflicted by cognitive errors might invest Social Security unwisely. Insufficient self control and cognitive errors might consigns people to poverty-ridden old age
It is good to pause from time to time and reevaluate programs, such as Social Security, set decades ago. The deficit accompanying our crisis compels us into such reevaluation. We should consider the rationale for Social Security and its advantages and drawbacks before we proceed to revise it.

“In anxious times people seek cover in gold,” wrote the New York Times in November 2010, as the price of an ounce of gold crossed the $1,400 bar. “People are coming in to buy 50 or 100 coins at a time, which is hefty for individuals,” said a coin broker. “It’s not just rich people, either. A lot of people are putting 30 to 35 percent of their net worth in gold; they are scared to put money in paper assets. ”

Fear is driving up the price of gold yet there is reason for fear. It was not long ago that we have lost almost half of the value of our stocks, unemployment is still hovering around 10 percent, budget deficits are huge, money is printed in enormous quantities, and currency wars are brewing. Still, even a gold-bull is concerned that the price of gold has shot too high. “It’s beginning to smell a little like the beginning stages of a bubble,” he said.

We are all gripped by fear from time to time, yet fear is not a good investment guide. Few accidents are more horrifying than airplane crashes, yet the fear elicited by such disasters depresses stock beyond reason. Aviation disasters cause actual losses lower than $1 billion on average, but the loss in the value of stocks following an aviation disaster averages more than $60 billion.

We are less willing to take risk when we are frightened than when we are calm. In one experiment, a group of students were offered money to stand before the class the following week and tell a joke. A flat joke can be embarrassing, so it is not surprising that some students who agreed to tell a joke withdrew in fear when the time came to stand and tell a joke. But students who were frightened were more likely to withdraw than students who were not. Half the students in the experiment were shown a fear-inducing film clip from The Shining, Stanley Kubrick’s classic horror film, before deciding whether to tell a joke or withdraw. It turned out that a greater proportion of them withdrew.

Fear misleads us to avoid risk even when it is wise to take risk. Here is an investment game: I’ll toss a coin right before your eyes. If it comes out heads, I’ll pay you $1.50. If it comes out tails, you’ll pay me $1. We’ll play 20 rounds of this game. Before each round you can choose to participate or sit it out. Ready? Suppose that you have lost three dollars in the first three rounds because all three tosses came out tails. Do you choose to participate in the fourth round or do you choose to sit out?

Three losses in a row would arouse fear in normal investors. Many choose to sit out the fourth round. But there is no good reason to be afraid because the game is stacked in favor of those who play all 20 rounds. In each round we have a 50/50 chance to lose $1 or gain $1.50. Our maximum loss is $20 while our maximum gain is $30. And even if we lose, a $20 loss is hardly catastrophic. Yet brain-damaged players were more reasoned at the game than normal players. Undeterred by fear, brain-damaged players played more rounds of the game than normal players and won more money.

There is a lesson here for normal investors. Fear grips us when we watch our portfolios day by day and see so many losing days. Fear grips us even more strongly when we watch losses in our portfolios over many months or even years, as happened in 2008 and early 2009. Fear urges us to sell our stocks and invest the money in gold or put it under a mattress. Our emotional response is normal, but it gets in the way of wise behavior.

Why Small Investors Can’t Beat Buffett
NEW YORK (TheStreet) — Meir Statman, business professor and author of What Investors Really Want, explains why small investors are better off owning index funds than trying to beat the pros. Click here to watch.

I was recently interviewed by Singapore based Business Times. They were kind enough to let me post the article on this blog.

Business Times – 02 Oct 2010

Self-awareness is power
Knowing yourself, your goals, and errors is the first lesson in behavioural finance. By Genevieve Cua

BUY-AND-HOLD investing came in for a hammering with the crisis of 2008, as did diversification. Thanks to deep losses in the recent downturn, more advisers have begun to trade client portfolios more actively at the margins, an exercise called ‘tactical’ asset allocation – or, to put it more plainly, market timing. But this practice came in for a beating at a talk earlier this week at the Private Wealth Management Conference organised by the CFA Institute.

In a talk laced with humour, Meir Statman , Glenn Klimek professor of Finance at Santa Clara University, had a very clear message for investors and advisers. Prof Statman’s research focuses on behavioural finance. The first lesson, he says, is to know yourself, your goals, and errors. The second is to assure yourself by knowing not just the science of financial markets and instruments, but also the science of human behaviour. He likens financial advisers to financial physicians. ‘Physicians take care of your health, and financial advisers your wealth and well being . . . Good financial advisers have to listen, empathise, educate. That’s a big job. ‘In standard finance, investors are rational. In behavioural finance, they are normal. People are not rational, they are normal. Sometimes we are normal smart, sometimes normal stupid. It would be nice if we could increase the ratio of smart to stupid, but we’re always people.’ People, he says, have been disappointed by diversification, which failed to provide any cushion from loss at the worst of the crisis. Assets in a portfolio are picked for their low correlations with each other, so that they should not rise or fall in tandem. But in a crisis, correlations among most assets spike.

‘Diversification assures you that you won’t have all your eggs in the crummiest asset. But it also means you won’t have your entire portfolio in the best. But you’d be in between. ‘People say I’m disappointed. There must be something better – market timing, tactical asset allocation. It’s tempting, but it’s the equivalent of jumping from the frying pan into the fire.’ He cites a joint study with Kenneth Fisher, to ascertain if the implementation of PE trading rules work. Between 1871 and 2002, US$1 invested in the stock market grew to about US$67,000 using a buy-and-hold mode. In contrast, a trading rule of investing whenever PEs dropped below 26 times would have netted roughly US$60,000. If market timing isn’t a panacea, why do many people – finance professionals included – believe that it is? A number of human traits can explain this: Overconfidence; ‘representative’ error which is the human tendency to find patterns where they may not exist. The latter error blurs the line between hindsight and foresight.

Trading, in any case, is a zero sum game, he says. ‘If I think the market is too high and I sell, someone else is buying it. There is an idiot in every trade and if you don’t know who it is, you’re in trouble . . .’You have to ask yourself: . . . What’s my information advantage to give me an edge? In all likelihood it’s nothing, you’re deluding yourself.’ Investors, he says, can protect themselves by making advisers their allies. ‘To advisers, I say make yourself worthy of the designation. ‘Knowing that you commit cognitive errors is the first step. The second is to remind yourself. Like me, you probably have problems creating defences.’ Advisers, he says, ‘have to continuously be teachers of our clients’. ‘You can’t say I told you that, that you know fear will cause you to be risk averse. You have to teach them again and again.’

While modern portfolio theory (MPT) is routinely taught in finance schools, it is impractical in practice. MPT has a number of key assumptions – that investors are rational and risk averse; that there are no trading costs, for instance. It points investors to ‘optimal’ portfolios which represent a combination of assets that give the maximum return for a given level of risk. The theory implies just one level of risk tolerance, says Prof Statman. ‘But we build portfolios not as a whole, as prescribed by (Harry) Markowitz, but in a pyramid. We buy money market funds for downside protection and stocks and lottery for the upside.’

Together with Hersh Shefrin, Prof Statman published a paper in 2000 on ‘behavioural portfolio theory’. It posits that investors have multiple mental accounts, and the resulting portfolio does not coincide with a traditional portfolio based on MPT and an efficient frontier. The behavioural portfolio basically is a two-level pyramid where the lower layer is designed to avoid poverty, and the higher layer is designed ‘for a shot at riches’. Risk tolerance itself may be linked to culture. Prof Statman has written a paper on this – The Cultures of Risk Tolerance. He finds that people who are more trusting, for instance, are more willing to take risk. Those from countries where incomes are relatively low are more willing to take risk. In ‘collectivistic’ societies, where there is a family network and cohesive ties, risk tolerance is also higher. This could be because an extended family provides a downside cushion.

At the other end of the spectrum is the ‘individualistic’ society where individuals are expected to look after themselves. Singapore and China rank fairly low on the individualistic scale, and the highest ranked are the US and UK. Prof Statman himself keeps his investments ‘very, very simple’. ‘What do I do in a crazy market? I invest and close my eyes rather than try to pick out where the mania will go; it’s self-defeating. ‘It’s very hard to explain to clients, but I think the way to do it is to say – here is what we know from science. Here are some studies I can show you about how people try to take advantage of cycles and fail.’ Once you’ve made the plunge to invest, switch off the noise from news commentators, he says. ‘I keep my investments very, very simple, and I think I’ve done very well. I invest exclusively in index funds and let stuff take its course. I have enough money in my downside protection account to make sure I’m not going to be poor. ‘The money in my upside account, I don’t do options. The stuff I have in equities, sometimes it goes up and it goes down. I shrug, what can I do? ‘If you train yourself to be like that, you will do yourself a great favour. It’s hard, (an adviser’s) business is transaction oriented, because I’m not going to give you much business. I don’t trade. I think (that’s) smart behaviour.’

Think of an investor who had a $2 million portfolio in October 2007, $1 million in bonds and $1 million in stocks. Visit him again in February 2009 when his bonds are still worth $1 million but his stocks are worth only $500,000. What should he do now? Should he re-balance his portfolio? And, if so, how should he re-balance?

The initial portfolio was a 50/50 stock/bond portfolio and the standard advice is to re-balance back to a 50/50 portfolio by selling $250,000 worth of bonds and using the proceeds to buy $250,000 of stocks. This advice flows from two distinct reasons, one related to risk tolerance and the other to expected returns.

The risk tolerance reason is that an investor who has chosen a 50/50 portfolio has declared that his risk tolerance corresponds to an optimal 50/50 portfolio. The February 2009 portfolio is a 33.3/66.7 stock/bond portfolio, so it is sub-optimal. The portfolio can be made optimal again by restoring it to its 50/50 proportions.

The expected returns reason is that securities returns tend to be mean-reverting, so it is likely that the returns of stocks would be high relative to their long-term mean following periods where their returns were low relative to their mean, and the same is true for bonds. If our world of returns is a mean-reverting world then investors benefits by buying stocks just before their returns are especially high and selling them just before their returns are especially low. In a recent exchange of letters to the editor of the Financial Analysts Journal, William Bernstein argued that our world is a mean-reverting world while William Sharpe argued that it is not clear that this is our world.

The re-balancing answer of behavioral portfolio theory is quite different from these two answers. The investor with a $2 million portfolio chose to invest $1 million in stocks and $1 million in bonds because he has two distinct goals reflected in two mental accounts or “buckets.” Being-rich is one goal, and that is the purpose of the $1 million in stocks. Not-being-poor is the other goal, and that is the purpose of the $1 million in bonds. We can think of the not-being-poor goal as the goal of retirement at a basic level of comfort. We can think of the being-rich goal as the goal of enjoying luxuries in retirement or leaving a substantial bequest to children or charity.

A “behavioral investor” might well object to selling bonds from his not-being-poor mental account because the proceeds of such sales might be lost if invested in stocks, diminishing his basic level of comfort in retirement. Our investor has good reason to refuse the usual re-balancing advice and financial advisers should listen to him.